Question

The question provided is related to Chapter 29, "Business Cycles, Unemployment, and Inflation."

Question: Can a government achieve a low inflation rate and low unemployment?

Prepare between 2 to 4 pages or 500 to 1000 words for this discussion.

Answer 1

Yes it is absolutely possible. There are two approaches to achieving this, one being orthodox and the other heterodox.

First, in economics, there is something called the Philips curve - the trade off between inflation and unemployment. This means that to have low unemployment, one must endure not-so-low inflation, and vice versa. However, a central bank that has a low inflation target (e.g. 2%), can facilitate both low inflation and low unemployment (full employment) - a dual mandate - if it is able to build adequate credibility so that markets (businesses, investors, consumers) are anchored to its inflation target. The logic is that with a non-credible central bank, economic shocks would tend to raise inflation expectations beyond the central bank’s target, and prices would rise (nominal wages rise in expectation of higher inflation, interest rates rise on investors’ expectations of higher inflation) etc., and thus unemployment rises more sharply in such an environment. But with a credible central bank, markets are confident that any increases (or decreases) in inflation beyond (or under) the central bank’s target would be reigned back in by the central bank. Thus, when shocks occur, unemployment is less likely to increase as inflation rises. Additionally, with inflation expectations strongly anchored to the central bank’s inflation target, monetary easing and the ensuing decrease in unemployment can more easily occur without causing much inflation. Applied practically, Marvin Goodfriend shows that it was because inflation and inflation expectations were well-anchored to the Federal Reserve’s policy that the Fed was able to cut interest rates aggressively in 2001 from 6.5 to 1.75 percent to cushion the fall in aggregate demand and employment.

When both inflation and unemployment are mitigated, economic growth is driven by complementary economic policies (which I will not go into because there are a diversity of prespciptions from a diversity of economic schools of thought) - just know that maintaining low inflation & UE is the hard part because there is typically a trade off. Nonetheless, within the same logic, with low inflation due to strong anchor to the central bank’s policy, persistently low interest rates is feasible to maintain a higher equilibrium of investments that drive economic growth.

The heterodox approach sees labour costs as a significant source of inflation (as it is a significant composition of production costs, and is susceptible to wage-price spirals, as was the case in the U.S. In the 1970s that James Kenneth Galbraith prescribed wage controls). Before the philips curve, there was the Sultan curve - which showed a trade off between wage inflation and unemployment. Therefore, if wage moderation/restraint can be guaranteed, then inflation would be subdued. Additionally, with subdued wage inflation, the philips curve becomes steeper, such that full employment policies can be more easily pursued without inflation rising. This configuration facilitated low unemployment, low inflation, and economic growth. Again, although there is some endogeneity of economic growth within the narrated logic (e.g. Low inflation permitting lower interest rates to spur investments for economic growth), economic growth is pursued by their means I shall not explain here.

The traditional (Rein-Meider) Swedish model included: centralized and coordinated wage bargaining (between labour unions and employer organizations, and the state) to guarantee wage moderation (I.e. wage increases limited to productivity growth), while the state committed to an anti-inflationary policy (so that real wages are not threatened) complemented by policy measures designed to preserve ‘full and productive employment’ - which was achieved through wage moderation (such that more employment could be afforded at such moderated wages), Active Labour Market Policies (ALMP), as well as other policy measures.